We provide a Keynesian growth theory in which pessimistic expectations can lead to very persistent, or even permanent, slumps characterized by high unemployment and weak growth. We refer to these episodes as stagnation traps, because they consist in the joint occurrence of a liquidity and a growth trap. In a stagnation trap, the central bank is unable to restore full employment because weak growth depresses aggregate demand and pushes the policy rate against the zero lower bound, while growth is weak because low aggregate demand results in low profits, limiting firms’ investment in innovation. Aggressive policies aiming at restoring growth, such as subsidies to investment, can successfully lead the economy out of a stagnation trap by generating a regime shift in agents’ growth expectations.

This research has been supported by the ESRC British Academy Mid-Career Fellowship grant ES/I024174/1, the Spanish Ministry of Science and Innovation (grant ECO2011-23192), the Fondation Banque de France Research Grant, the CERCA Programme/Generalitat de Catalunya and the Spanish Ministry of Economy and Competitiveness, through the Severo Ochoa Programme for Centres of Excellence in R&D (SEV-2015-0563).